Is the College Debt Bubble Starting to Crack?

A financial bubble is where a rapid expansion in a particular market or asset is followed by a steep contraction. Prices often rise far above where they should be, considering fundamentals or intrinsic value. The aftershocks of the housing bubble still plague many Americans, but an even bigger bubble is raising red flags.

The skyrocketing price of a college education is causing an epidemic with student loans as more people rack up unsustainable amounts of debt to further their education. These loans are often bundled together and sold in a bond offering. While the appetite for risky assets is strong as the Federal Reserve punishes savers with low interest rates, investors are not willing to take a chance on some bonds backed by student loans.

Sallie Mae, the largest non-government student lender, was recently forced to cancel a $225 million bond offering after two weeks on the market, according to people familiar with the deal and The Wall Street Journal. The lender was reportedly trying to sell the bonds with a 3.5 percent coupon, in a deal led by Bank of America (NYSE:BAC).

Bonds based on student loans are quite popular. According to Bank of America, Sallie Mae and other issuers of the securities have sold almost $8 billion worth of bonds year-to-date, compared to only $5.7 billion in the same period last year. However, investors and students both have their limits.

Students are more likely than ever to take out a loan to pay for college. The average price of college tuition increases 8 percent a year, meaning the cost of tuition doubles about every nine years. This outpaces almost every other kind of inflation that is widely tracked. Using debt to obtain a degree can be beneficial if done properly, but a weak job market and stagnant incomes are weighing on graduates.

Borrowers are struggling to repay student loans. In only the first two months of 2013, banks have declared $3 billion of student loan debt as noncollectable, according to Equifax’s latest National Consumer Credit Trends Report. This represents a 36-percent surge from the same period last year.

“Driven heavily by economic factors, including unemployed or under-employed consumers going back to school along with the rising cost of tuition, student lending has demonstrated consistent, year-over-year growth,” said Equifax Chief Economist Amy Crews Cutts. “Continued weakness in labor markets is limiting work options once people graduate or quit their programs, leading to a steady rise in delinquencies and loan write-offs.”

Research done by the Federal Reserve and Equifax also paints a dismal picture for student loans. Outstanding student loan balances increased $10 billion during the fourth quarter of 2012 to reach a total of $966 billion. Even more concerning was that the number of borrowers who have fallen behind on their student debt by at least 90 days continued to climb higher. In the fourth quarter, it surpassed the delinquency rates of credit cards to reach 11.7 percent. Thirty-five percent of people under 30 years old who have student loans are at least 90 days late on payments, compared to 26 percent in 2008.

Interestingly, the delinquency rates of student loans are likely even higher than reported. In the fine print, the Fed explains, “These delinquency rates for student loans are likely to understate actual delinquency rates because almost half of these loans are currently in deferment, in grace periods or in forbearance and therefore temporarily not in the repayment cycle. This implies that among loans in the repayment cycle delinquency rates are roughly twice as high.”

Student loans continue to see strong demand and are not heavily dependent on credit history or income of the borrower. This is eerily similar to subprime lending that occurred in the housing bubble. However, student loans are not typically allowed to be discharged in bankruptcy, due to changes made several years ago.

In an effort to examine more recent shifts in the student debt bubble, FICO conducted a study reviewing loan data from 2005. With the cost of college easily outpacing broad inflation gauges, FICO found that approximately 12 million Americans had two or more open student loans on their credit report in 2005. In 2012, this figure more than doubled to 26 million Americans.

Adding insult to injury, consumers also have a greater amount of student loan debt today. In 2005, consumers in the United States with at least one open student loan on record had an average student debt load of $17,233. However, this debt load increased 58 percent to $27,253 last year. In comparison, all other debt categories combined only grew 4.3 percent.

In addition to higher average balances, the percentage of consumers with student debt has increased at every level. Consumers with student debt under $20,000 increased from 9.0 percent in October 2005 to 11.0 percent in October 2012. Those with student debt in the $20,000 to $39,999 range more than doubled from 1.9 percent to 4.0 percent. Consumers in the ranges of $40,000 to $59,999 and $60,000 to $79,999 also more than doubled over the past seven years.

Meanwhile, those with student loan debt in excess of $100,000 quadrupled in the same time period. In other words, there are approximately 1.2 million more consumers with student loan debt in excess of $100,000.The rising debt levels and delinquency rates are concerning, especially since the Consumer Financial Protection Bureau says total student debt outstanding has already surpassed $1 trillion, easily topping total credit card debt and auto loan debt.